How Do I Know If My 401(k) Is Top-Heavy?

In line with the constantly evolving financial landscape, the Internal Revenue Service (IRS) regularly updates the regulations surrounding retirement plans, including 401(k)s.

One critical provision in these guidelines is encapsulated in Section 416 of the Internal Revenue Code (IRC), which outlines the conditions under which a 401(k) plan is considered to be top-heavy.

Specifically, a 401(k) plan becomes top-heavy when more than 60% of its total assets are held by key employees.

Updated Definition of Key Employees for 2023

The IRS has revised the criteria for identifying key employees. For 2023, key employees are defined as follows:

• Officers of the company receiving compensation in excess of $215,000 for the year 2023, $200,000 for 2022, and $185,000 for the years 2020-2021. These figures are adjusted annually for inflation.
• Individuals who own more than 5% of the business stock or capital.
• Owners who earn over $150,000 (not adjusted for inflation) and hold more than a 1% ownership stake in the company.

Nondiscrimination Tests and Equitable Access

The IRS mandates that all company-sponsored 401(k) plans undergo a series of nondiscrimination tests annually to ensure equitable access to retirement benefits. Among these tests, the top-heavy test plays a crucial role in ascertaining that key employees do not inordinately benefit from the 401(k) plan at the detriment of other employees.

Summary and Best Practices

The regulatory updates for 2023 underscore the IRS’s commitment to ensuring that retirement benefits are uniformly accessible across all levels of an organization. It is of paramount importance for companies to be cognizant of these changes and to consult with qualified tax professionals for guidance on maintaining compliance with these ever-changing regulations.

Small business 401(k) plans, particularly those experiencing high employee turnover, are at a greater risk of being classified as top-heavy compared to their larger counterparts. Larger organizations typically employ a diverse range of staff, including many who are not in management positions, thereby diluting the concentration of assets held by key employees.

Conversely, small businesses—especially those that have evolved from a closely-held ownership structure such as a family or spousal partnership—are more susceptible to having their asset distribution skewed in favor of key employees, unless contributions are also being made for the broader workforce.

The Importance of Monitoring for Top-Heavy Test Failures

It’s crucial to recognize that failing the top-heavy test is not only a common compliance issue but also one that can be particularly expensive to rectify. Therefore, understanding the likelihood that your 401(k) plan could be considered top-heavy is essential for both compliance and financial planning.

By staying vigilant and being aware of the factors that contribute to a top-heavy 401(k), organizations can take proactive measures to ensure equitable asset distribution and avoid costly corrective actions.

The determination dates are the first and last days of the plan year, so December 31st. This means that a plan failing the first year will also be top-heavy for the following year.

• Consider which participant balances are excluded – such as those with rollover accounts from past employers or the balances of terminated employees.
• Add on distributions made on account of termination, retirement, loans or early distributions, and death.

If you’re worried about the top-heavy test, you can:

• Encourage non-key employees to increase their contributions by providing educational materials
• Incentivize participation with a modest matching contribution
• Request that key employees reduce or cease their contributions
• Make a profit-sharing contribution to all employees
• Allow previously ineligible participants into the plan by removing the vesting schedule
• Add a mid-year Safe Harbor match

Some steps will not help you pass testing. For instance, you can’t take a mid-year disbursement, which the IRS expressly forbids. You also can’t simply terminate or demote a key employee, as all funds contributed so far are still factored in. Additionally, you can’t cancel the plan or make a correction for funds already contributed.

One of the best ways to pass a top-heavy test is to add a Safe Harbor provision to your plan. You may choose to:

• Contribute a 100% match on the first 3% of saved dollars and 50% on the next 2%,
• Contribute a flat 3% of each non-key employee’s salary, OR
• Match the highest contribution percentage of any key employee

Best of all, employer contributions are tax-deductible. You have until October 1st for the Safe Harbor provision to go into effect at the start of the next year.

For help in choosing the right type of small business retirement plan, contact Ubiquity to schedule a free consultation. Attract and retain your workforce with our uncomplicated, flat-fee retirement savings plans.